Corporate Finance
MLI28C060
Lecture 14
Thursday 27 October 2016
Exam Structure
• 2 Parts
• 3 Hours duration (start 9am with finish at 12 midday)
• First Part: Two Numerical calculation questions (30
marks each)
– Maximum – 60% of marks
• Second Part: Three short answer questions – each
question is worth 20 marks
– Maximum – 40% of marks
WACC and Capital Budgeting
Cost of Equity and Debt
• Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)
k e  k rf   (k m  k rf )
Where
ke
krf
km
β
= expected rate of return on equity
= risk free rate on bonds
= expected rate of return on the market
= coefficient of firm’s systematic risk
• The normal calculation for cost of debt is analyzing the various
proportions of debt and their associated interest rates for the firm
and calculating a before and after tax weighted average cost of debt
Estimating the Cost of Debt
• For developed countries, the target’s local or the acquirer’s home country
cost of debt.
• For emerging countries, the cost of debt (k d ) is as follows:
k d  R f  CRP  FRP
where
Rf = Local risk free rate or U.S. treasury bond rate converted to a local nominal
rate if cash flows are in the local currency; if cash flows in dollars, the U.S.
treasury rate
CRP = Specific country risk premium expressed as difference between the local
country’s (or a similar country’s) government bond rate and the U.S. treasury
bond rate of the same maturity
FRP = Firm’s default risk premium (i.e., additional premium for similar firms
rated by credit rating agencies or estimated by comparing interest coverage
ratios used by rating agencies to the firm’s interest coverage ratios to
determine how they would rate the firm.)
Weighted Average Cost of Capital
k WACC
E
D
 k e  k d (1  t)
V
V
Where
kWACC = weighted average cost of capital
ke
= risk adjusted cost of equity
kd
= before tax cost of debt
t
= tax rate
E
= market value of equity
D
= market value of debt
V
= market value of firm (D+E)
Capital Budgeting
Net Present Value (NPV)
• Net Present Value (NPV): Net Present Value is
found by subtracting the present value of the
after-tax outflows from the present value of
the after-tax inflows.
9-8
Net Present Value (NPV)
• Net Present Value (NPV): Net Present Value is
found by subtracting the present value of the
after-tax outflows from the present value of the
after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
9-9
Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows
with the present value of the inflows.
• The IRR is the project’s intrinsic rate of return.
9-10
Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows
with the present value of the inflows.
• The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
9-11
NPV Profile -- Multiple IRRs
Net Present Value
($000s)
75
Multiple IRRs at
k = 12.95% and 191.15%
50
25
0
-100
0
40
80
120 160
Discount Rate (%)
200
Payback Period (PBP)
0
-40 K
1
2
3
10 K
12 K
15 K
4
5
10 K
7K
PBP is the period of time required for
the cumulative expected cash flows
from an investment project to equal
the initial cash outflow.
Payback Solution (#1)
0
-40 K (-b)
Cumulative
Inflows
2
3 (a)
10 K
12 K
15 K
10 K (d)
7K
10 K
22 K
37 K (c)
47 K
54 K
1
4
PBP
=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
5
Critical appraisal of all three techniques
Comparing Methods
Basis of
measurement
Measure
expressed as
Strengths
Limitations
Payback
period
Cash
flows
Number
of years
Easy to
Understand
Net present
value
Cash flows
Profitability
Dollar
Amount
Considers time
value of money
Internal rate
of return
Cash flows
Profitability
Percent
Considers time
value of money
Allows
Accommodates Allows
comparison
different risk
comparisons
across projects levels over
of dissimilar
a project's life projects
Doesn't
Difficult to
Doesn't reflect
consider time
compare
varying risk
value of money dissimilar
levels over the
projects
project's life
Doesn't
consider cash
Hedging methods
• Two contexts: A/R versus A/P
• 4 HEDGING METHODS
–
–
–
–
UNHEDGED
FORWARD
MONEY MARKET
OPTION
– See the worked calculations/seminars
Strategy Choice and Outcome
Hedging Strategy
Outcome/Payout
Remain uncovered
Unknown
Forward Contract hedge @ $1.754/£
$1,754,000
Money market hedge @ 8% p.a.
$1,755,396
Money market hedge @ 12% p.a.
$1,772,605
Put option hedge @ strike $1.75/£
Minimum if exercised
$1,722,746
Maximum if not exercised
Unlimited
Concepts
Corporate governance: International comparative
governance: The structure of Multinational
Enterprises (MNEs) and Business Groups
Structure:
- MNE and Business Group structure
- Introduction to transfer pricing
- Introduction to expropriation via “shareholder tunneling”
Reading:
Claessens, S., Djankov, S. & Lang, L. H. P. (2000). The separation of ownership and
control in East Asian corporations. Journal of Financial Economics, 58, 81-112
Khanna, T., & Palepu, K. (2000). Is group affiliation profitable in emerging
markets? An analysis of diversified Indian business groups. Journal of Finance,
55(2): 867-891
Khanna, T., & Rivkin, J. W. (2001). Estimating the performance effects of business
groups in emerging markets. Strategic Management Journal, 22: 45-74
Khanna, T., & Yafeh, Y. (2007). Business groups in emerging markets: Paragons or
Parasites? Journal of Economic Literature, 45(2): 331-372
Business Groups and MNE’s
• Part 1 – Hard control
– Pyramiding
– Cross shareholder networks
• Part 2 - Soft control
– Shared directors between constituent firms
– Director interlock
– Presidential clubs (e.g. Japanese keiretsu)
Part 1 – Hard control
• Pyramiding
Firm 1
>51%
Minorities <49%
Firm 2
>51%
Minorities <49%
Firm 3
>51%
Minorities <49%
Firm 4
Profit
repatriation/
tunnelling
Part 1 – Hard control
• Cross shareholder networks
Firm 2
Firm 1
Firm 4
Firm 3
Part 2 – Soft Control
• Shared directors amongst firms
• Socialization – e.g. through common training and/or
“presidential clubs” (e.g. Japanese keiretsu)
• Director “interlock”
Institutions and legal systems
What are institutions?
• Institutions are the humanly devised
constraints that structure political, economic
and social interaction. They consist of both
informal constraints (sanctions, taboos,
customs, traditions, codes of conduct), and
formal rules (constitutions, laws, property
rights)
• D.C. North, The Journal of Economic Perspectives, 1991.
Institutions defined (again)
• Douglas North: ”Institutions are the humanly
devised constraints that structure human
interaction. They are made up of formal
constraints1, informal constraints2 and their
enforcement characteristics. Together they define
the incentive structure of societies and
specificially economies”.
– 1) rules, laws, constitutions
– 2) norms, behavior, conventions
• … or simply ’the rules of the game’
Why civil society is key –
Institutional and normative set-up of international finance
Figure: Ideal
influence
patterns
Differences in Legal system
Civil Code vs. Common Law
• Features of Civil Code law (as opposed to
common law)
- Inquisitorial (vs. accusatorial)
- Code-based (vs. case law)
- History: Roman Law
- Branches: public / private – criminal / civil
- Career judges
- Written proceedings (vs. oral proceedings)
Comparison of Civil-Law and Common-Law
Systems (III)
• Manner of legal reasoning
- Civil-Law → Deductive
- Common-Law → Inductive
• Structure of Courts
- Civil-Law → Integrated Court system
- Common-Law → Specialty Court system
• Trial process
- Civil-Law → Extended process
- Common-Law → Single-event trial
Comparison of Civil-Law and
Common-Law Systems (IV)
• Judges
- Role in trials.
* Civil-Law → elevated role
* Common-Law → «referee»
- Judicial attitudes.
*Civil-Law → mere appliers of the law
* Common-Law → search creatively for an answer
- Selection and training.
* Civil-Law → a part of the civil service
* Common-Law → selected from a political process
So…….there are 2 questions:
•1: where (location) do we raise finance?
•2: what type of finance do we use?
• Firms almost always exhaust internal sources
of capital first before considering external
sources – why?
• Answer: Internal sources draw on ”Internal
Capital Market” within firm and it’s network
(network in case of business groups or family
firms)
• Entrepreneurial firms – lifecycle:
– Internal sources exhausted by entrepreneur
(friends, family and business groups in case of
network economies)
– Then Business Angels (BA) early stage investors
– Then Venture Capital (VC)
– The ultimate goal/aim is for firm to achieve a stock
market IPO (Intitial Public Offering)
• Normally after internal sources bank
finance/lending is preferable to external
capital markets – why?
• One answer is ”informational” i.e.
– For a firm to issue bonds to external investors
there are huge costs in terms of auditing,
accounting transparency, issuing prospectuses etc
– This is in order to provide investors with
confidence through firm incurring ”bonding costs”
as in bonding with investors
– Alternative is bank lending – with relationship
with bank mitigating informational costs
• Bank lending is also a useful indicator to
investors
– i.e. if banks continue to supply credit to firm then
given their close relationship – this is a good sign
of credit-worthiness of firm
– The presence of banking relationships thus
impacts positively on value of firm’s equity and
debt (bonds)
• Now………. Where do firm’s raise finance:
• This has everything to do with costs of debt
and costs of equity
– This is the subject of tommorow’s (Friday’s)
lecture